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The Challenges of Risk Management in Diversified Financial Companies Christine M. Cumming and Beverly J. Hirtle The Challenges of Risk Management in Diversified Financial Companies • Although the benefits of a consolidated, or n recent years, financial institutions and their supervisors firmwide, system of risk management are Ihave placed increased emphasis on the importance of widely recognized, financial firms have consolidated risk management. Consolidated risk traditionally taken a more segmented management—sometimes also called integrated or approach to risk measurement and control. enterprisewide risk management—can have many specific meanings, but in general it refers to a coordinated process for • The cost of integrating information across measuring and managing risk on a firmwide basis. Interest in business lines and the existence of regulatory consolidated risk management has arisen for a variety of barriers to moving capital and liquidity within reasons. Advances in information technology and financial a financial organization appear to have engineering have made it possible to quantify risks more discouraged firms from adopting consolidated precisely. The wave of mergers—both in the United States and risk management. overseas—has resulted in significant consolidation in the financial services industry as well as in larger, more complex financial institutions. The recently enacted Gramm-Leach- • In addition, there are substantial conceptual Bliley Act seems likely to heighten interest in consolidated risk and technical challenges to be overcome in management, as the legislation opens the door to combinations developing risk management systems that of financial activities that had previously been prohibited. can assess and quantify different types of risk This article examines the economic rationale for managing across a wide range of business activities. risk on a firmwide, consolidated basis. Our goal is to lay out some of the key issues that supervisors and risk management • However, recent advances in information practitioners have confronted in assessing and developing technology, changes in regulation, and consolidated risk management systems. In doing so, we hope to breakthroughs in risk management clarify for a wider audience why the ideal of consolidated risk methodology suggest that the barriers to management—which may seem uncontroversial or even consolidated risk management will fall obvious—involves significant conceptual and practical issues. during the coming months and years. We also hope to suggest areas where research by practitioners and academics could help resolve some of these issues. Christine M. Cumming is an executive vice president and the director of The authors would like to thank Gerald Hanweck, Darryll Hendricks, Chris research and Beverly J. Hirtle is a vice president at the Federal Reserve Bank McCurdy, Brian Peters, Philip Strahan, Stefan Walter, Lawrence White, and of New York. two anonymous referees for many helpful comments. The views expressed are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. FRBNY Economic Policy Review / March 2001 1 The approach we take is to review the arguments made by views, using a simple portfolio model to help illustrate the supervisors and the financial industry in favor of consolidated economic rationale behind consolidated risk management. risk management. While both parties agree on the importance Next, we discuss the constraints that have slowed many of this type of risk management, this support seems to be financial institutions in their implementation of consolidated motivated by quite different concerns. Supervisors appear to risk management systems. We conclude with a discussion of support it out of a safety-and-soundness concern that the major technical challenges and research questions that will significant risks could be overlooked or underestimated in the need to be addressed as an increasing number of financial firms absence of firmwide risk assessment.1 In contrast, financial implement firmwide risk management systems. institutions appear willing to undertake significant efforts to Our goal is to lay out some of the key Consolidated Risk Management: issues that supervisors and risk Definitions and Motivations management practitioners have confronted in assessing and developing At a very basic level, consolidated risk management entails a coordinated process of measuring and managing risk on a consolidated risk management systems. firmwide basis. This process has two distinct, although related, dimensions: coordinated risk assessment and management across the different types of risk facing the firm (market risk, develop consolidated risk management systems because they credit risk, liquidity risk, operational risk), and integrated risk believe that those systems will help them assess the risk and evaluation across the firm’s various geographic locations, legal return of different business lines and thus allow them to make entities, and business lines. In theory, both dimensions must be more informed decisions about where to invest scarce addressed to produce a consolidated, firmwide assessment of 2 resources to maximize profits. While these two views may risk. In practice, few financial firms currently have in place a reflect quite different underlying motivations for supporting consolidated risk management, we argue below that they result in a common emphasis on the importance of accurate The absence thus far of fully implemented assessments of risk. Although both supervisors and financial institutions consolidated risk management systems support the concept of consolidated risk management, few if suggests that there are significant costs or any financial firms have fully developed systems in place today. obstacles that have historically led firms to The absence thus far of fully implemented consolidated risk management systems suggests that there are significant costs or manage risk in a more segmented fashion. obstacles that have historically led firms to manage risk in a more segmented fashion. We argue that both information costs and regulatory costs play an important role here by affecting consolidated risk management system that fully incorporates the trade-off between the value derived from consolidated risk both dimensions, although many large institutions—both in management and the expense of constructing these complex the United States and overseas—appear to be devoting risk management systems. In addition, there are substantial significant resources to developing such systems (Joint Forum technical hurdles involved in developing risk management 1999a).3 systems that span a wide range of businesses and types of risk. To understand consolidated risk management, it is Both of these factors are evolving in ways that suggest that the important to recognize the distinction between risk barriers to consolidated risk management are increasingly measurement and risk management. Risk measurement entails likely to fall over the coming months and years. the quantification of risk exposures. This quantification may The remainder of this article is organized as follows. In the take a variety of forms—value-at-risk, earnings-at-risk, stress next section, we describe the concept of consolidated risk scenario analyses, duration gaps—depending on the type of management in greater detail and provide a more in-depth risk being measured and the degree of sophistication of the discussion of the views of supervisors and the financial industry estimates. Risk management, in contrast, refers to the overall about this process. We then offer a critical analysis of these process that a financial institution follows to define a business 2 The Challenges of Risk Management strategy, to identify the risks to which it is exposed, to quantify for describing the risk management process to encompass the those risks, and to understand and control the nature of the role of business strategy and the activities of business line risks it faces. Risk management is a series of business decisions, decision makers.6 The Committee also set out an approach to accompanied by a set of checks and balances—risk limits, the supervisory review of a bank’s internal assessment of capital independent risk management functions, risk reporting, adequacy in light of a firm’s overall risks as the second pillar of review and oversight by senior management and the board of the proposed new capital adequacy framework (Basel directors—in which risk measurement plays an important, Committee on Banking Supervision 1999b). although not all-encompassing, role. Thus, consolidated risk Recently, an international forum of banking, securities, and management involves not only an attempt to quantify risk insurance supervisors issued a report containing principles that across a diversified firm, but also a much broader process of supervisors should follow to ensure that financial business decision making and of support to management in conglomerates are adequately identifying and managing risk. order to make informed decisions about the extent of risk taken The report’s lead recommendation is that “supervisors should both by individual business lines and by the firm as a whole. take steps . to provide that conglomerates have adequate risk Recent trends in the financial services industry have management processes in place to manage group-wide risk increased the challenges associated with this process. To begin, concentrations” (Joint Forum 1999a). financial institutions increasingly
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